§ The additional $140 million comes from reduction in taxes
§ $400 million is shielded from corporate taxes, providing
the tax savings of 35% * $400 million = $140 million
§ This gain to investors is referred to as the interest tax
shield
Interest Tax Shield = Corporate Tax Rate * Interest
Payments
§ The Interest Tax Shield and Firm Value
§ Cash Flows to Investors with Leverage
= Cash Flows to Investors without Leverage + Interest Tax
Shield
§ MM Proposition I with taxes:
The total value of the levered firm exceeds the value of the
firm
without leverage due to the PV of the tax savings from debt:
V
L
= V
U
+ PV(Interest Tax Shield)
§ The Interest Tax Shield and Firm Value
§ Given a forecast of future interest payments, we can
determine the interest tax shield and compute its PV by
discounting at a rate that corresponds to its risk
§ The Interest Tax Shield with Permanent Debt
§ Consider the case in which the firm issues debt and keeps it
constant (ex. Perpetual consol bond, or debt refinancing)
§ Assuming that the debt is risk free,
§ The Interest Tax Shield with Permanent Debt
§ If the debt is fairly priced, its market value must equal the PV
of future interest payments
§ Market Value of Debt = D = PV(Future Interest Payments)
§ WACC with Taxes
§ Suppose a firm with a 35% tax rate borrows $100,000 at 10%
interest per year
§ The effective cost of debt is only 6.5%
§ WACC with Taxes
§ The tax deductibility of interest lowers the effective cost of
debt financing for the firm
§ More generally,
With tax-deductible interest, the effective after-tax borrowing
rate is r(1
− t
c
)
§ WACC with Taxes
§
§
